A tax is a financial charge imposed upon an individual or legal entity by government to fund various public expenditures.Tax is a kind of money which it is the legal duty of very citizen of a country to pay honestly. It may be levied on income , property and even at the time of purchasing a commodity.a failure to pay tax is usually punishable by law.
Types of taxes
The most fundamental classification of taxes is based on who collects the taxes from the tax payer.there are two types of taxes direct and indirect taxes.
- Direct Taxes
that are directly paid to the government by the taxpayer. It is a tax applied on individuals and organizations directly by the government e.g. income tax, corporation tax, wealth tax etc.
- Indirect Taxes
are applied on the manufacture or sale of goods and services. These are initially paid to the government by an intermediary, who then adds the amount of the tax paid to the value of the goods / services and passes on the total amount to the end user. Examples of these are sales tax, service tax, excise duty etc.
impact and incidence of taxes:
Impact of taxation refers to the immediate burden of the tax. The impact of a tax is the immediate result of the imposition of a tax on the person who pays it in the first instance.
Incidence of a tax is the settlement of the tax burden on the ultimate tax-payer. The incidence of a tax refers to the money burden of a tax on the person who ultimately bears it. The incidence of a tax remains upon that person who cannot shift its burden to any other person.
In short, we can say , the impact of taxation is on the producer while incidence of taxation on the consumers. The impact of tax can be shifted while incidence of tax cannot be shifted.
Effect of Taxes on Supply and Demand
Taxes reduce both demand and supply, and drive market equilibrium to a price that is higher than without the tax and a quantity that is lower than without the tax.Tax authorities usually require either the buyer or the seller to be legally responsible for payment of the tax. Tax incidence is the way in which the burden of a tax is shared among the market participants. Taxes will typically constitute a greater burden for whichever party has a more inelastic curve – e.g., if supply is inelastic and demand is elastic, the burden will be greater on the producers.
Suppose that a state government imposes a tax upon milk producers of $1 per gallon.e original price for milk was $2 per gallon. After imposition of the tax, the supply curves shift up and to the left. Consumers pay $2.60 per gallon. Sellers receive $1.60 per gallon after paying the tax. So sixty cents of the tax is actually paid by consumers, while forty cents is paid by the milk producers.as shown in the figure.
Incidence of Tax
The triangle ABC above represents the dead weight loss due to taxation, which occurs because now there are fewer mutually beneficial exchanges between buyers and sellers. Dead weight loss stems from foregone economic activity and is a loss that does not lead to an offsetting gain for other market participants; it is a permanent decrease to consumer and/or producer surplus.
Specific and ad valorem taxes:
There are two types of indirect tax; specific and ad valorem.
- A specific unit tax
A unit tax is a set amount of tax per unit sold, such as a 10p tax on packets of cigarettes.
- An ad valorem tax
an ad valorem tax is a percentage tax based on the value added by the producer. For instance, if the market value of a 2,000 square-foot home is $100,000, the ad valorem tax levied will be based solely on the home’s $100,000 value, regardless of its relative physical size. Municipal property taxes are an example of an ad valorem tax. One advantage of ad valorem taxes is that the tax revenue to the government can rise automatically as the economy grows. This means that the tax rate does not need to be adjusted frequently, as in the case of specific unit taxes, such as duties on cigarettes and alcohol.
The imposition of either type of indirect tax has an effect similar to a rise in production costs. This means that a firm’s supply curve will shift up vertically by the amount of the tax.
A specific unit tax
A specific unit tax will shift up the supply curve by the full amount of the tax, so that the new curve is parallel to the original one, as shown.
An ad valorem tax
The imposition of an ad valorem tax will shift up the supply curve by a certain percentage, meaning that the new supply curve will not be parallel to the original.
Average and marginal rates of taxation:
An average tax rate is the ratio of the total amount of taxes paid to the total tax base (taxable income or spending), expressed as a percentage.In a proportional tax, the tax rate is fixed and the average tax rate equals this tax rate. In case of tax brackets, commonly used for progressive taxes, the average tax rate increases as taxable income increases through tax brackets, asymptoting to the top tax rate. For example, consider a system with three tax brackets, 10%, 20%, and 30%, where the 10% rate applies to income from $1 to $10,000, the 20% rate applies to income from $10,001 to $20,000, and the 30% rate applies to all income above $20,000. Under this system, someone earning $25,000 would pay $1,000 for the first $10,000 of income (10%); $2,000 for the second $10,000 of income (20%); and $1,500 for the last $5,000 of income (30%). In total, they would pay $4,500, or an 18% average tax rate.
The average tax rate is calculated by dividing the total income taxes paid by your total income.
total income taxes paid
average tax rate (ATR) = —————————
A marginal tax rate is the tax rate an individual would pay on one additional dollar of income. Thus, the marginal tax rate is the tax percentage on the last dollar earned. In the United States in 2013, for example, the highest marginal federal income tax rate was 39.6%, applying to earnings over $400,000. Earnings under $400,000 that year had a lower tax rate of 33% or less.
Proportional, Progressive and Regressive taxes:
Under a regressive tax system, individuals and entities with low incomes pay a higher amount of that income in taxes compared to high-income earners. Rather than implementing a tax liability based on the individual or entity’s ability to pay, the government assesses tax as a percentage of the asset that the taxpayer purchases or owns.
For example, a sales tax on the purchase of everyday products or services is assessed as a percentage of the item bought and is the same for every individual or entity. However, a sales tax of 7% has a greater burden on lower-income earners than it does on the wealthy because the ability to pay is not taken into consideration. Regressive taxes include real estate property taxes, state and local sales taxes as well as excise taxes on consumables such as cigarettes, gasoline, airfare or alcohol.
A proportional tax system, or a flat tax system, assesses the same tax rate to taxpayers regardless of income or wealth. It is meant to create equality between marginal tax rate and average tax rate paid. Under a proportional tax system, individual taxpayers pay a set percentage of their income regardless of total income earned.
For example, an income tax of 10% that does not increase or decrease as income rises or falls results in a proportional tax. In this example, an individual who earns $20,000 annually pays $2,000 under a proportional tax system, while someone who earns $200,000 each year pays $20,000 in taxes. Some specific examples of proportional taxes include per capita taxes, gross receipts taxes and occupational taxes.
The current federal income tax is a progressive tax system, in that the proportion of tax liability rises as an individual or entity’s income increases. Tax burdens are meant to be more of an imposition to wealthy, high-income earners than they are to low- or middle-class individuals.
Under a progressive tax system, taxes assessed on income and business profits are based on a progressive or increasing tax rate schedule. Marginal tax rates under a progressive tax system are often higher than the average tax rates that are paid. Estate taxes are another example of progressive taxes, as a greater burden is placed on wealthy individuals.
the Canons of Taxation:
A tax has no connection with the benefit received by the payer. Also, the charge is compulsory.Hence in distributing the burden of taxation, a person’s share cannot be decided with reference to the benefit derived by him.
Adam Smith laid down four principles to guide the taxing authority.
Adam Smith’s Canons:
The principles or canons of taxation enunciated by Adam Smith were so important that they have become classic.
- Canon of Equality:
“The subjects of every State,” Smith asserted, “ought to contribute towards the support of the Government as nearly as possible in proportion to their respective abilities, that is, in proportion to the revenue which they respectively enjoy under the protection of the State. In the observance or neglect of this maxim consists what is called the equality or inequality of taxation.” Equality here does not mean that all tax-payers should pay an equal amount. Equality here means equality or justice. It means that the broadest shoulders must bear the heaviest burden.
- Canon of Certainty:
Adam Smith further said, “The tax which each individual has to pay ought to be certain and not arbitrary. The time of payment, the amount to be paid ought all to be clear and plain to the contributor and to every other person.” The individual should know exactly what, when and how he is to pay a tax otherwise it will cause unnecessary suffering. Similarly, the State should also know how much it will receive from a tax.
- Canon of Convenience:
Smith wrote, “Every tax ought to be levied at the time or in the manner which it is most likely to be convenient to pay it.” Obviously, there is no sense in fixing a time and method of payment which are not suitable. Land revenue in India is realised after the harvest has been collected. This is the time when cultivators can conveniently pay.
- Canon of Economy:
Lastly, Adam Smith held that “every tax ought to be so contrived as both to take out and keep out of the pockets of the people as little as possible over and above what it brings into the public treasury of the State.” This means that the cost of collection should be as small as possible. If the bulk of the tax is spent on its collection, it will take much out of the people’s pockets but bring very little into the State’s pocket. It is not a wise tax.
Other Canons of Taxation:
Economic science has progressed much since the days of Adam Smith. Later writers have added to his canons.
The additions are:
(5) Canon of Productivity:
This canon emphasizes that a tax should bring in a substantial amount of money to the State. After all, the main object of the taxing authority is to secure funds. Therefore, a tax which does not yield a fair income is not of much use. It is much better to have a few taxes which yield good revenue instead of many taxes yielding a little.
(6) Canon of Elasticity:
This canon points out that a tax should automaticaly bring in more revenue as the country’s population or income increases. There should be an automatic link between the needs of the State and resources of the people. If, in an emergency, an increase in the rate of the tax brings in increased income, the tax is elastic.
(7) Canon of Simplicity:
It argues that the tax system should be simple; otherwise there would be confusion and, worse still, corruption. During the war and after, certain taxes, e.g., on sale of cloth and lather essential supplies in India resulted in corruption mainly because they lacked in simplicity.
(8) Canon of Variety:
It is also necessary that the tax system off a country should be diversified. Reliance on just a few taxes is risky. The revenue will not be sufficient, nor will it be fair, because it will not touch a large number of people. In order to be just, a tax system must be broad-based. In order to be adequate, it must be diversified, having a wide coverage over commodities and persons.
(9) Canon of Flexibility:
‘Flexibility’ in taxes is different from ‘elasticity’ mentioned earlier as a canon. Flexibility connotes the absence of rigidity in the tax system. A flexible tax quickly adjusts to the new conditions; on the other hand, elasticity means that income can be increased. Presence of flexibility is a pre-condition for elasticity. Lack of flexibility in a tax can cause financial troubles to a State.
=Written by Tehmeena=